Capital Market Outlook Q4 2017
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1 It amazes me how people are often more willing to act based on little or no data than to use data that is a challenge to assemble. - Robert Shiller Summary Capital Market Outlook Q4 207 The Yale Nobel laureate economist emphasizes data driven decision making. JWM has always taken that approach, both with investment recommendations and performance monitoring, and Professor Shiller is correct in pointing out that it can often be a challenge. We will continue to approach client portfolios using this strategy. The highlights of our outlook are as follows: The U.S. economic growth in the 2 nd Quarter was.%. The U.S. dollar has declined recently, with the potential impact for a positive impact on net trade balances. Total inflation remains well below Fed targets, both for core and headline statistics. The Fed has indicated at least one more interest rate increase in 207 and the start of its balance sheet reduction. U.S. equities are at the high end of historical valuations but earnings growth remains positive. Global growth is positive in most markets, and equity valuations are generally reasonable. Emerging market economic performance, perhaps other than China, is expected to continue to strengthen. Energy prices appear to have stabilized and activity remains high in economical oil and gas plays and midstream activity. Economy The final revision to U.S. 2 nd Quarter GDP was.%, more than double the st Quarter and the strongest since the st Quarter of 20 (Chart ). Growth was driven by private inventory building, an acceleration in personal consumption ( PCE ), and lower imports, while lower exports and residential fixed construction were a drag. The United States lost,000 jobs in September as the economy was impacted by Hurricanes Harvey and Irma. It was the first monthly decline in jobs in seven years and also broke a 90 month streak of private sector job growth. The jobless rate dropped to 4.2%, the lowest since 200 (Chart 2). Inflation remains low in 207. The core CPI, less food and energy, rose 0.2% in August and.7% for the trailing year. The core PCE deflator, watched more closely by the Federal Reserve ( Fed ), was at.% for the trailing year, falling from the same statistic in July (Chart ). This is well below the Fed target of 2.0% and will likely remain benign for the near term. The continued low inflation has impacted Fed policy. The Fed objective of raising its policy interest rate was paused at the September meeting, although they did indicate another hike in 207. They also laid out their plan for unwinding their balance sheet and took a more aggressive stance than expected (Chart 4). The U.S. economy outlook remains positive. The September PMI issued by the Institute for Supply Management was 60.8, up 2% from August. Federal government regulation roll back continues, and while the recent hurricane damage had regional growth impact, the reconstruction will add to GDP activity. The effect of any tax rate reduction legislation, currently being discussed, likely will have a positive effect if passed. GDP forecasts for 207 have generally been revised upward, with the larger impact expected in 208. Earlier this year, international forecasters announced the first global growth upgrade since 200. August PMI readings for all but Korea and Thailand were above 0, the traditional level above which growth is expected. Developed markets are all solidly positive, although Asian emerging markets are weaker, and European emerging markets have experienced recent weakening. Developed Europe is forecasted to outperform the U.S. in economic growth both for this year and next. The weakening of the U.S. dollar relative to the Euro recently may affect the international trade balances in the forecasts (Chart ). The immigration issues in Europe, and the attendant political changes are still not fully resolved. Nevertheless Euroland growth is improving. Emerging markets are mixed. China continues to slow, but policy efforts in their election year are being made to support stable growth. Any major impact on international trade of recent Chinese currency upward valuations has not yet occurred. In the remaining emerging economies, growth expectations are slowing but are still positive. African economies are the wild card, with political issues outweighing economic activity. Event risks remain: North Korean belligerence, Chinese and Russian meddling, Middle East conflicts, and international terrorism.
2 Equity Markets U.S. equity markets continued to rise, supported in part by continued Fed liquidity. In the rd Quarter, the S&P 00 rose 4.% and the tech heavy NASDAQ composite advanced 6.2%. For the year to date, they were up 4.2% and 24.0%. Throughout 207, growth stocks have significantly outpaced value stocks. Corporate performance continues to grow, with the majority of U.S. companies beating revenue and/or earnings estimates in the 2 nd Quarter. For 208, earnings growth is expected to be in the 0% range with positive growth expected for the remainder of 207. Market volatility remains low, and while equity valuations are at the high end of historical ranges, they appear to be fullyrather than over valued (Chart 6). Further, the conditions for a market top, such as record inflows to equity market funds, increased IPO and merger activity, weakening earnings outlook, or widening credit spreads, are all absent. The slowing of the Fed response, GDP growth and the potential for tax rate reduction all support the continuation of stock market performance in the U.S., albeit with expected pullbacks along the way. International developed market equities also delivered a strong quarter with the MSCI ACWI ex US up 6.2%, and MSCI EAFE returning.4%. A portion of this performance was due to a weaker dollar, but primarily to strong performance in local currencies. Further, Euroland equity valuation, both on a priceto earnings basis, and price to book basis, are trading closer to historical averages than U.S. markets. Emerging market equities continue to rebound, with the MSCI Emerging Markets index up 7.9% for the quarter and 27.8% for the year to date. However, the performance is not uniform across all countries, and almost 6% of the index is weighted to four countries: China, South Korea, Taiwan, and India. Active management and country specific allocation remain the preferred method for investing in EM equities. Interest Rates The yield on the 0 U.S. Treasury continues to trade in a band between 2% and 2.% (Chart 7). The current fair value of the 0 Treasury is in the range of 2.4% to 2.6%, depending on assumptions of growth and inflation. The interest rate spreads in the U.S. remain tight, and there has not been any major steepening of the yield curve. Interest rate risk remains a concern. The high yield debt market continues to improve in credit quality and default reduction. With the modest increases in oil prices, the energy related high yield issues have improved. For the year to date, high yield bonds have returned 7%. While spreads have tightened, there is still an opportunity assuming additional credit quality improvements. Emerging market debt appears positive, but again is country specific. With the decline of the U.S. dollar, improvements in local currency returns are enhanced for U.S. investors. Energy and Commodities Oil markets are trading in the $0/Bbl WTI range (Chart 8). Saudi Arabia continues to promote production cuts to support prices, but there is disagreement among producers and the usual cheating. U.S. inventories were affected by Hurricane Harvey. With many shale plays profitable at this level, drilling has resumed. We expect U.S. production to continue an upward trend and hit record levels in 208. Natural gas prices continue to languish in the $/Mmcf range. This is partly due to lower than usual seasonal demand, and to uncertainty in the pace of coal to natural gas power generation with revisions to some coal regulation. Nevertheless, with increasing LNG exports, and high propane prices, we expect natural gas pricing to improve. Energy Master Limited Partnerships (MLPs) After producing an 8.% return in 206, MLPs have underperformed in 207. The Alerian Index was down.% for the rd Quarter. MLP share prices have limited equity funding as a source of capital for existing MLPs. In addition, the midstream assets of exploration companies that were traditionally a source of growth for the MLP industry are instead being acquired by private equity capital. However, with active drilling requiring transportation and storage facilities, increasing construction of fractionation plants to capture liquids and flared gas, and increased LNG and oil exports including expansion plans, there is large demand for midstream capacity, both in transportation and processing. Throughout this period, distributions have remained steady or increased. The current yield of the MLP funds, which are tax efficient for current income, are generally approaching or even exceeding 0%. We continue to recommend MLPs. JWM Strategy Our Current Allocation Strategy is attached. We continue to emphasize an overweight allocation to U.S. equities relative to international, short duration for fixed income coupled with a diversified mix of non traditional income assets. We are closely monitoring core real estate assets, particularly in the multi family space, due to the high and continuing levels of new construction over the last few years and concerns about lease up in new projects. Thank you for your continued confidence in JWM.
3 Chart The final revision to U.S. 2 nd Quarter GDP was.%, more than double the st Quarter and the strongest since the st Quarter of 20. Growth was driven by private inventory building, an acceleration in personal consumption and lower imports. U.S. GDP Chart 2 The United States lost,000 jobs in September as the economy was impacted by Hurricanes Harvey and Irma. It was the first monthly decline in jobs in seven years. The jobless rate dropped to 4.2%, the lowest since 200. he U.S. economy added 222,000 jobs in June. The unemployment rate rose slightly to U.S. Unemployment 4.4%, but this was due to an increase in the labor force participation rate. Average wages continue to increase, up 2.% for the trailing year. Source: Tradingeconomics.com, U.S. Bureau of Economic Analysis Chart Inflation remains low in 207. The core PCE deflator, the Federal Reserve s preferred measure was at.% for the trailing year, falling from July. This is well below the Fed target of 2.0% and will likely remain benign near term. U.S. Inflation Source: Yahoo Finance, U.S. Bureau of Labor Statistics Chart 4 The Fed balance sheet run off will begin in Q4 207 at $0 Billion per month. The cap will be raised by $0 Billion each quarter until it reaches $0 Billion per month. There was no guidebook for the Fed's balance sheet to grow so large and there is no guidebook now on how to shrink it back down. Fed Balance Sheet Source: Advisor Perspectives, dshort.com Source: Capital Economics, Federal Reserve, Thomson Reuters
4 Source: FactSet. J.P. Morgan Asset Management Source: WTRG Economics Chart The U.S. dollar has declined for most of 207 before strengthening late in the rd quarter on hopes of tax rate reductions and reaffirmation of plans by the Fed to increase interest rates at the December FOMC meeting. U.S. Dollar Index Chart 6 Equity valuations are at the high end of historical ranges. However, the conditions for a market top, such as record inflows to equity market funds, increased IPO and merger activity, weakening earnings outlook, or widening credit spreads, are all absent. Domestic Equity Valuations Source: Federal Reserve Bank of St. Louis Source: Factset, FRB, Thomson Reuters, Robert Shiller, S&P and J.P. Morgan Asset Management Chart 7 The yield curve continues to flatten. The yield on the 0 U.S. Chart 8 Oil markets are trading in the $0/Bbl WTI range. U.S. inventories were Treasury has been trading in a band between 2% and 2.%. The current fair value affected by Hurricane Harvey. With many shale plays profitable at this level, of the 0 Treasury is in the range of 2.4% to 2.6%, depending on assumptions drilling has resumed. We expect U.S. production to continue an upward trend and of growth and inflation. hit record levels in 208. U.S. Interest Rates Oil Prices & Active Rigs
5 JWM Current Allocation Strategy Q4 207 Overall portfolio target allocations reflect customized client Investment Policy. The current JWM strategy within various assets classes is outlined below: Income Assets Significant Neutral Significant Underweight Underweight Weight Overweight Overweight Target Within Income Assets Traditional Fixed Income 0% Cash & Equivalents US Government Bonds Municipal Bonds US Corporate Bonds High Yield Bonds Convertible Bonds Floating Rate/Bank Loans Eurozone Bonds Developed Markets Other Emerging Market Bonds Non Traditional Income Assets 0% Master Limited Partnerships (MLP's)/Energy Preferred Stocks Conservative Allocation Funds Diversified Income Equities Target Within Equities US Equities 6% Large Cap Mid Cap Small Cap Hedged Equity International % Eurozone Developed Markets Other Currency Hedged International Emerging Markets Alternative Investments Core Alternatives Opportunistic Alternatives Target Within Alternative Varies by Client
6 Market Index Returns - September 207 Equity Returns Income Asset Returns Russell Style Index Returns Q US Fixed Income Maturity & Quality Returns Q Large Cap Government/Corporate Mid Cap 2... Municipal Bonds Small Cap High Yield Value Blend Growth Short Intermediate Long Large Cap Government/Corporate Mid Cap Municipal Bonds Small Cap High Yield Value Blend Growth Short Intermediate Long - - Large Cap Government/Corporate (0.8) Mid Cap Municipal Bonds Small Cap High Yield Value Blend Growth Short Intermediate Long Domestic Equities Q - Traditional Fixed Income Q - Russell BofAML US Convertible S&P S&P/LSTA Leveraged Loan.0.0. Dow Jones Industrial Average Barclays Global Aggregate Bond ex-usd (2.4) NASDAQ Composite JPM EMBI Global Diversified (USD) JPM GBI-EM Global Diversified (Local Currency) International Equities Non-Traditional Income Assets MSCI ACWI ex-us Alerian MLP Index (.) (.6) (.7) MSCI EAFE (Developed) BofA ML Preferred Stock Fixed Rate MSCI EAFE Hedged (Developed) DJ Mortgage REIT MSCI Emerging Markets Source: Morningstar; JWM believes the data is representative, but cannot guarantee its accuracy. All calculations represent total return and are annualized for periods exceeding year.
7 Market Index Returns - September 207 Broad Index Domestic Equity Traditional Fixed Income S&P Barclays US Treasury Bills MSCI USA Minimum Volatility Barclays US Treasury - Intermediate (0.6) 0..6 (0.7) S&P High Yield Dividend Aristocrats Barclays Municipal (0.7) DJ Industrial Average Barclays Gov't/Corp - Intermediate (0.) NASDAQ 00 (0.) Barclays US Aggregate Bond (0.) Russell BofA ML US High Yield Master Russell BofAML US Convertible Russell Mid Cap S&P/LSTA Leveraged Loan Russell Barclays Global Aggregate Bond ex-usd (.) (2.4) 0.2 (0.7) 2.6 Style Index JPM EMBI Global Diversified Russell 000 Growth JPM GBI-EM Global Diversified (0.) (0.9).8 Russell 000 Value Non-Traditional Income Assets Russell Mid Cap Growth Alerian MLP Index 0.7 (.) (.6) (.7) (2.9) (0.6) 6. Russell Mid Cap Value BofA ML Preferred Stock Fixed Rate Russell 2000 Growth DJ Mortgage REIT Russell 2000 Value Income Assets 0 Broad Index International Equity MSCI ACWI Ex USA MSCI US REIT (0.) (0.7) MSCI EAFE CBOE S&P 00 Buywrite MSCI EAFE Hedged CBOE Market Volatility (VI) (0.2) (4.9) (2.) (28.4) (6.) (9.6) (6.2) MSCI EAFE Minimum Volatility Bloomberg Commodity (0.2) 2. (2.9) (0.) (0.4) (0.) (6.8) MSCI EM (0.4) S&P 00 Sectors 0 MSCI EM Minimum Volatility (0.) Energy (6.6) 0.2 (.7).0.0 MSCI Frontier Markets (.4) Materials Regional/Country Index Industrials MSCI Canada Consumer Discretionary MSCI UK Consumer Staples (0.9) (.4) MSCI EMU Health Care MSCI Japan Financials MSCI EM EMEA (.9) 6... (.) (.9) (.8) Information Technology MSCI EM Asia (0.0) Telecom Services. 6.8 (4.7) (0.) MSCI EM Latin America (0.) (.9) (0.8) Utilities (2.7) Index Miscellaneous 0
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